Macroeconomics 9: The basics of Short-run Macroeconomics

Question 1

Set the scene for the basics of short-run macroeconomics

Answer 1

The key insight is that, in the short-run, prices are fixed (sticky)
Aggregate Demand determines real output and supply adjusts to the level of demand.
We will use the long-run model expressions for the components of demand for goods:
consumption (slightly adjusted), investment, government expenditure, net exports (open
economy).
Because prices of goods are fixed, there is a role for money in influencing aggregate
demand and hence having short-run effects on the real economy. The mechanisms are:
Through the exchange rate for a small open economy with open capital markets
(Mundell-Fleming model)
Through both interest rate and exchange rate for a large open economy with open capital
markets

Question 2

Describe sticky prices in the short run

Answer 2

Why should prices be rigid in the short run?
- because of the way firms set prices
- because of the way in which nominal wages are determined
Not all prices are sticky in the short run e.g. commodity and financial asset prices
* Firm pricing behaviour:
1. menu costs
2. search behaviour - ‘Search behaviour’ says that when consumers want to buy goods n services, they might do a deep search for the product at an optimal price. This introduces search models where consumers are faced with a whole range of prices. But once the consumer chooses a certain supplier, they’re more likely to ‘stick’ to the supplier for future purchases cos they ‘trust’ them. If this ‘stickiness’ exists, then firms must realise that if they increase prices, consumers might go to another supplier. So in the short-run, firms are reluctant to change prices, constributing to why prices are sticky in the short-run. Also, when we have more unemployment. firms can increase productivity without increasing wages and thus prices
3. coordination failure - In reality, firms operate in a segmented market - monopolistic competition - firms produce goods in a sorta contained way and their are all sorts of consumers for a particular good and firms try to have a USP. This contributes to ‘sticky prices’ because if a certain niche increases prices, other firms may not do so as they aren’t the EXACT same product (so don’t have to follow the same equilibrium) and so that firm loses customers
* Wage-setting behaviour
* (implicit) contracts keep workers in jobs and (nominal) wages relatively fixed
* efficiency wages make it costly for firms to reduce wages
* trade unions and legal structures can slow wage adjustment in the short run

Question 3

Describe & explain the concept of expectations & shocks and why short-run macroeconomics is important for this

Answer 3

• The long-run model incorporates forward looking behaviour:
  1. Households saving
  2. Firms’ investment
• If a predictable change in economic conditions happens (e.g. demographic changes) then the long-run
  model should explain the behaviour of the economy since wages and prices will adjust to the change
• If a change is unexpected then it will shift the economy away from long-run equilibrium since wages and
  prices take time to adjust. This is why we need a short run model.
• How do we decide what is expected and unexpected? Under the theory of rational expectations
  individuals are using all available information so an unexpected change means that new information has
  become available
• Shocks can be aggregate demand based e.g. an unexpected fall in consumption or supply-side driven e.g.
  an unexpected increase in energy prices. Shocks can, of course, be positive as well as negative.(See
  Mankiw p. 274-5 for more examples)…

Question 4

Describe & explain the IS curve for a small open economy

To start, what does it essentially do?

Answer 4

• It describes the short run relationship between Y and r in the Goods Market
• We model the aggregate demand curve using the structure of demand introduced in the long-run model.
• In the open economy there are four components of aggregate demand
  1. Household - Consumption: C=a+b(Y-Tstar) C=consumption and Y is output/Income, T is (lump - sum) taxation, Parameter ‘a’ represents the minimum consumption (subsistence), Parameter ‘b’ is the marginal propensity to consume

Graph with x-axis “Y” and y-axis “C” titled “Consumption” with straight positive line that start a point on y-axis

2. Firm - Investment: I=d-frstar
   I is firm capital investment, rstar is the global real interest rate, Parameter ‘d’ is the maximum amount of investment the firm could undertake when borrowing costs are zero, Parameter ‘f’ is the interest rate sensitivity of firm capital investment

Graph with x-axis “I” and y-axis “r” titled “Investment” with straight negative line that starts at a point on y-axis. Also, dotted horizontal and vertical lines meeting at a point on the curve. Vertical line labelled “I(rstar)” at x-axis and horizontal line labelled “rstar” at y-axis

3. Government - Expenditure and Taxation: Government expenditure = Gstar and Government taxation = Tstar
4. Foreign - Net Exports: NX(ε)= ω - (μ x eP / p∗) = ω- γe where γ=μ x P/P∗ and γ is constant
   Parameter ω is the maximum level of net exports while μ is the real exchange rate sensitivity of NX

Graph with x-axis “NX” and y-axis “e” titled “Net Exports” with straight negative line that starts at a point on y-axis. Also, 2 dotted horizontal and vertical lines each, a pair of which meet each at a point on the curve. Left vertical line labelled “NX(ebottom right0)” at x-axis, right vertical line labelled “NX(ebottom right1)” at x-axis, top horizontal line labelled “ebottom right0” at y-axis and bottom horizontal line labelled “ebottom right1” at y-axis*

Graph with x-axis “Y” and y-axis “AD” with 2 parallel straight positive lines that both start a point on y-axis. Bottom line labelled “C+I(rstar+Gstar+NX(ebottom right1)” and Top line labelled “C+I(rstar+Gstar+NX(ebottom right0)”. Upward arrow from bottom line to top line. Also, a dotted y=x line is present, labelled “Y=AD”. 2 dotted vertical lines from y-axis. One is where bottom line and Y=AD meet labelled “Y0” at x-axis and one for the top line, labelled “Y1” at x-axis.*

Graph with x-axis “Y” and y-axis “e” titled “IS Curve (for Small Open Economy, r=rstar” with straight negative line “ISstar(rstar)”. Also, 2 dotted horizontal and vertical lines each, a pair of which meet each at a point on the curve. Left vertical line labelled “Y0” at x-axis, right vertical line labelled “Y1” at x-axis, top horizontal line labelled “ebottom right0” at y-axis and bottom horizontal line labelled “ebottom right1” at y-axis*

Question 5

Describe & explain the LM curve for a small open economy

To start, what does it essentially do?

Answer 5

• It describes the short run relationship between Y and r in the money market
  The demand for real money balances can be written as Mbottom rightd/P = L(Y,i) with dL/dY>0 and
  dL/di<0
  We use a linear version Md/P =ky-lr
  k is the income sensitivity of money demand
  l is the interest rate sensitivity of money demand
  Under fixed prices πtop righte=π=0 so i=r. (Note that we can have π>0 or <0 and use the short-run
  model as long as relative prices don’t change i.e. all prices and wages rise at the same rate
  π)
  With Y given, we can draw a downward sloping relation between Md/P and r which we write
  as L(r).The LM Curve

The following is the model for the Money Market Equilibrium and it contributes to constructing the LM curve:
Graph titled “Money Market Equilibrium” or “The Market for Real Money Balances” with x-axis, “Real Money Balances, M/P” and y-axis, “Interest rate, r”. There’s a straight vertical line from the x-axis called “Supply” and at this point of the x-axis, there’s a label, “Mbar/Pbar”. There’s also a curve with a negative gradeint but positive d^2 y / dx^2 called “Demand, L(r)”. Where the 2 lines cross is the point, “Demand for money at a
given value of Y”. From this point, there’s a dotted horizontal line going to the y-axis, “Equilibrium Interest Rate”.

Constructing the LM curve:
Now, redraw the graph just drawn up with title “(a) The Market for Real Money Balances”, but L(r,Y) shifts rightwards; so there’s an “L(r,Y1)” curve and a parallel “L(r,Y2)” curve on its right. Rightwards arrow from former to latter labelled “1. An increase in income raises money demand,…”. There’s still the coinciding respective “r1” and “r2” labels on the y-axis, each with dotted lines to where each curve meets “Mbar/Pbar”. Upwards arrow from r1 to r2 labelled “2. …increasing the interest rate”. Now, there’s another graph directly to the right of “(a) The Market for Real Money Balances” titled “(b) The LM Curve”; with x-axis, “Income, Output, Y” and y-axis, “Interest Rate, r”. There’s an upward sloping curve on this graph (with a small positive d^2 y / dx^2 called “LM”. It’s also annotated with “3. The LM curve summarizes these changes in the money market equilibrium”. Now, the r1 and r2 from graph (a) lines up with the LM graph, so the dotted lines from before extend all the way rightwards onto this graph (which also has matching up “r1” and “r2” labels) all the way until it meets the LM curve. There are now points on this LM curve where the dotted line meets. From these points, there are dotted vertical lines going down to the x-axis of graph (b) where there are respective labels: “Y1” and “Y2”.

Question 6

Describe graphically the relationship between Monetary Policy and the LM schedule

Answer 6

Graph titled “(b) The Market for Real Money Balances” with x-axis, “Real Money Balances, M/P” and y-axis, “Interest rate, r”. There’s a straight vertical line from the x-axis and at this point of the x-axis, there’s a label, “M1/P”. There’s also a curve with a negative gradeint but positive d^2 y / dx^2 called “L(r,YBar*)”. Where the 2 lines cross is a point. From this point, there’s a dotted horizontal line going to the y-axis, “r1” (at the y-axis)…